Economics 101: Are Trade Deficits Economic Negatives?

By at 22 May, 2019, 8:16 am

by Raymond J. Keating-

The current debate over trade policy too often and unfortunately veers off course from sound economics and history. One of the overarching themes among those advocating greater protectionist measures – such as tariffs and quotas – is that a trade deficit is an economic negative.

In reality, to the extent that the “balance of trade” matters at all, trade deficits are not economic negatives. SBE Council has pointed this out many times over the years. For example, in April 2018 congressional testimony, I noted the following about imports and trade deficits:

Given the current debate on trade, including policy decisions working against free trade, it is important to quickly point out that imports are not economic negatives, nor are trade deficits.

     On the imports front, growing imports correspond with expanding domestic production. That is, when the U.S. economy is growing, it is natural that imports of consumer, intermediate and capital goods commensurately increase. Also, imports aid the economy by boosting competition, which drives domestic businesses to be more innovative and to improve productivity. Again, consumers and domestic business, including small firms, wind up with increased choices and lower prices. In turn, those lower prices free up resources for saving, investing and making other purchases.

     Meanwhile, an expanding U.S. trade deficit usually signals strong U.S. economic growth. That is, periods of higher U.S. economic growth generally coincide with shrinking trade surpluses or mounting trade deficits, and economic slowdowns and recessions line up with declines in trade deficits. The U.S. trade deficit shrank dramatically during the most recent recession. The deficit also declined during the poor economy of 1990-91. And during the economic woes of 1979 to 1982, the trade deficit again declined notably, even moving to a trade surplus for two of those years. In contrast, periods of solid growth have seen the trade deficit expand, such as during 1982 to 1986, 1996 to 2000, and 2002 to 2006.

     Why is this? First, as noted previously, strong economic growth naturally drives demand for imports by both consumers and businesses. Second, a current account trade deficit (that is, a deficit in terms of goods and services) means there must be a capital account surplus (that is, a surplus in terms of investment moving into and out of the U.S.). That is, foreigners are viewing the U.S. favorably in terms of investment opportunities…

     Another point from [economist Richard] Rahn must be noted: “The U.S. government has been keeping foreign trade statistics since 1790. In the majority of years, the U.S. ran a trade deficit and an offsetting capital surplus (meaning more money was invested in the U.S. than U.S. companies and individuals invested in the rest of the world). The U.S., by productively using inexpensive foreign capital, was able to create the world’s biggest and wealthiest economy.”

     In fact, a growing U.S. economy is fed by investment, including from foreigners, and by expanding exports, with economic growth also reflecting and being further fed by being open to imports. In the end, when U.S. exports and imports are both growing, that’s good news for the U.S. economy, no matter what the trade deficit might be.

It was welcome to see the Federal Reserve Bank of St. Louis release an analysis on May 17th that further explored the history of trade deficits in the U.S., and make clear that such deficits are not economic negatives.

I have questions about some of the authors’ assumptions, such as hypothesizing on phases of industrialization. The authors also fall into the fallacy, or at least the bad habit of saying, that “nations” trade. For example, they write: “Since countries trade based on their comparative advantages, we would expect to see long-term changes to a country’s trade as it enters a new stage of development.” Countries, of course, do not trade. Individuals and businesses trade, and the concept of comparative advantage applies to individuals and businesses, i.e., where an individual or business focuses work or production where it has a comparative advantage, and then trades with others across town or around the world.

But there are basic points brought out in the Fed’s analysis that are not open to any real debate. They simply are facts, such as:

• “Running a trade deficit is nothing new for the United States. Indeed, it has run a persistent trade deficit since the 1970s—but it also did throughout most of the 19th century.”

• “From 1800-1870, the United States ran a trade deficit for all but three years and the trade balance averaged about –2.2 percent of GDP. Then from 1870-1970, it ran persistent trade surpluses that averaged about 1.1 percent of GDP. Starting in about 1970, the United States began to run trade deficits again, which have continued to this day.”

• During the 19th century, “Since countries trade based on their comparative advantages, we would expect to see long-term changes to a country’s trade as it enters a new stage of development. U.S. consumers benefited from imported manufactured goods, and furthermore, the United States could import capital goods to facilitate its own industrialization.”

• “The United States ran persistent trade deficits for large parts of its history, just as it does today. Trade deficits did not inhibit U.S. development, however, and may have even facilitated industrialization as the United States could import capital goods to improve its own manufacturing during its first phase of industrialization.”

Indeed, the capital account surplus that either drives or accompanies a current account (trade) deficit is a signal that foreign investors find the U.S. an advantageous place to invest no matter the so-called phase of industrialization, and that again, in turn, is good news for U.S. growth. When we get trade economics, facts and history correct, then sound policy – that is, the advancement of free trade policies that reduce or eliminate government obstacles to trade – should follow.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.


News and Media Releases